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Raghuram Rajan argues that income inequality, which has been on the rise since the 1970’s, can be explained in two ways. Progressive economists blame pro-rich policies. The “alternative” explanation (or, more accurately, the conservative view) focuses on skill-biased technological progress.
According to Rajan, while both explanations maintain that inequality led to excessive debt, causing the global economic crisis, only the “alternative” explanation accounts for European countries that maintained more egalitarian policies, despite low productivity. According to this view, Germany’s economic strength stems from the structural reforms – entailing fewer worker protections, limited wage increases, and reduced pensions – that were implemented to contend with historically high unemployment following reunification.
Now Southern Europe should implement similar reforms, Rajan argues, and accept the resulting increase in inequality, in order to avoid sliding into an “egalitarian decline” like Japan.
But Rajan’s analysis is problematic for three reasons. First, he establishes a largely artificial contrast between the two explanations of inequality’s causes. In fact, a progressive economist would be unlikely to deny that globalization and technological progress have increased income inequality – albeit to a lesser extent than Rajan believes. Likewise, a conservative economist would probably concede that pro-rich policies have fueled inequality (including in Europe, where the marginal income- and corporate-tax rates dropped dramatically almost everywhere).
Indeed, both phenomena probably contributed to the widening income gap. Skill-biased technological progress and competition from emerging economies undermined low-skilled workers’ value and, in turn, their political influence, resulting in unfavorable policies that exacerbated inequality.
The second problem is that Rajan’s analysis rests on the claim that inequality directly caused the crisis via debt accumulation. But this explanation fails to account for the disparities between the United States, where inequality’s link to the debt crisis is obvious, and the European Union, where it is more difficult to establish (except in Spain and Ireland).
In both the US and the EU, growing inequality depressed aggregate demand while motivating the wealthy to save more. Then, institutional differences and policy choices caused the US, where consumption was sustained by rising debt, to diverge from most European countries, where declining consumption led to low growth. Finally, the additional savings at the top financed asset bubbles (first in the stock market, and then in the housing market) and rising public debt in countries like the US, Spain, and Ireland, triggering the crisis.
Inequality thus contributed indirectly to the crisis by intensifying global imbalances, which imposed balance-of-payment constraints on growth in many advanced countries that continue to encumber recovery; but inequality did not directly cause the crisis. This interpretation, which accounts for the performance gap between Europe and the US, undermines Rajan’s basis for supporting the conservative explanation.
Finally, and most problematic, Rajan’s analysis assumes that increasing inequality is a necessary condition for sustained growth. Only by accepting structural reforms that reduce worker protections, he claims, can Europe recapture growth.
In his book Fault Lines: How Hidden Fractures Still Threaten the World Economy, Rajan complements this notion with a sort of “trickle-down” argument (wealth benefits all of society, regardless of whom, or how many, have it). But statistics show that median wages in most countries have stagnated, suggesting that wealth does not automatically trickle down.
Furthermore, the idea of a tradeoff between inequality and economic efficiency relies on a textbook dichotomy between the long run, in which only supply-side factors matter, and the short run, in which demand might also affect economic performance. Only in this idealized environment is the economy’s long-run efficiency, and hence its growth capacity, disconnected from income distribution. When the long and short runs are connected, the tradeoff becomes controversial, and may even vanish.
This argument represents the real divide between the conservative and progressive views. Many progressive economists, including Joseph Stiglitz and James Galbraith, deny the tradeoff’s existence. They contend that increased inequality hampers the economy’s capacity to produce wealth, and that a more egalitarian society would not only be ethically desirable, but would also stimulate growth, by, for example, attracting more productive firms (as in Scandinavia).
Moreover, Rajan’s claim that reducing labor-market protections would have only positive effects neglects the short-run advantages of such protections, which give workers the capacity to invest in their own human capital or to consume – and thus provide revenues for businesses. Just as austerity can be self-defeating to the extent that its short-run recessionary effects weaken long-run performance, reducing social protection might hamper an economy’s long-term growth capacity.
Rather than champion structural reforms based exclusively on their short-run effects, economists should abandon their reliance on mainstream supply-side theory. We must understand how the linkages between the short and long run render untenable the traditional dichotomy between an economy’s supply and demand sides – a dichotomy on which the argument in favor of structural reforms is based. Only then can we determine whether inequality is inhibiting growth. If it is, we need pro-growth policies that reduce it, not exacerbate it.